Choosing the right price is one of the hardest problems that a manager faces. It is also one of the most consequential: few other decisions have such immediate impact on the health and success of a firm. It is hardly surprising that firms devote considerable resources to deciding on the price to set. Even though firms operate in many different market settings, our analysis of markup pricing is very general: it applies to firms in all sorts of different circumstances. It is thus a powerful tool for understanding the behavior of firms in an economy.
One goal of this textbook is to help you make good decisions, both in your everyday life and in your future careers. In this chapter, we have set out the principles of how prices should be set, assuming that the goal of a manager is to make as much profit for a firm as possible. It does not necessarily follow, however, that this is how managers actually behave in real life. Does this chapter just describe a make-believe world of economists or does it also describe how prices are set in the real business world?
The answer is a bit of both. Managers must think carefully about costs and demand when setting prices. Market research firms routinely investigate consumers’ price sensitivities and estimate elasticities. At the same time, pricing decisions are sometimes more haphazard than this chapter might suggest. In practice, managers often use rules of thumb or standard markups that are not necessarily solidly based on the elasticity of demand.
There is one reason to think that managers do not stray too far from the prices that maximize their firms’ profits, however. Business is a competitive affair, and firms that make poor decisions will often not survive in the marketplace. If a firm consistently sets the wrong price, it will make less money than its competitors and will probably be forced out of business or taken over by another firm that can do a better job of management. The marketplace imposes a harsh discipline on badly managed firms, but the end result is—usually at least—a more efficient and better-functioning economy.
- College pricing: http://www.collegeboard.com/student/pay/add-it-up/4494.html
We suggested that a grocery store could conduct an experiment to find a demand curve by charging a different price each week for some product.
- Do you think that technique would be more accurate for a perishable good, such as milk, or for a nonperishable good, such as canned tuna? Why?
- Do you think the technique would be more accurate if the firm announced the price each week in advance or if it just let customers discover the different prices when they came to the store? Why?
- Extend Table 7.6.1 "Costs of Production: Increasing Marginal Cost" for output levels 6–10. What does Table 7.6.1 "Costs of Production: Increasing Marginal Cost" look like if the fixed cost is $100?
- Suppose your company is selling a product that is an inferior good. What do you think will happen to the demand curve facing your firm when the economy goes into recession?
- Suppose you are a producer of DVDs and imagine that producers of DVD players decrease their prices. What do you think will happen to the demand curve you face?
- If you were running a fast-food restaurant, what factors would you take into account in setting a price for burgers?
- Suppose a monopolist could produce an extra unit at zero marginal cost and, at the current price, faces a demand curve with an −(elasticity of demand) of 2. Should the monopolist raise or lower its price to make more profit?
- Suppose that instead of maximizing profit, the monopolist in Question 6 wants to maximize revenues. Would it behave any differently? What if the marginal cost was positive?
- If the price of steak is $25.00 a pound and the −(elasticity of demand) is 2, what decrease in price would lead the quantity sold to increase by 4 percent?
- Explain why marginal revenue must be less than the price when a firm faces a downward-sloping demand curve.
- A monopolist is maximizing profit. Perhaps due to an innovation in some other product line, he finds that the elasticity of demand for his product is lower. What will this change in the elasticity of demand due to the profit of the monopolist? How will the monopolist respond to this change?
The following is an excerpt from an article in the Singaporean newspaper, the Straits Times:
Singaporeans with a sweet tooth could soon find themselves paying more for their favourite treats, as bakers and confectioners buckle under soaring sugar prices.
Since March last year, the price of white sugar has shot up by 70 per cent, according to the New York Board of Trade. As if that didn’t make life difficult enough for bakers, butter and cheese prices have also risen, by 31 per cent and 17 per cent respectively.
The increases have been caused by various factors: a steep drop in Thailand’s sugarcane production due to drought, higher sea freight charges, increasing demand from China’s consumers for dairy products and the strong Australian and New Zealand dollar.
For the consumer in Singapore, what this may eventually boil down to is a more expensive bag of cookies, with prices at some bakeries expected to rise between 10 and 20 per cent.
[The owner of a Singapore bakery, Mr. Leong Meng Pock], said that he intends to raise prices possibly as early as next month. A sugared doughnut at his shop sells for 50 cents [about US$0.30] and a slice of Black Forest cake for $1.80 [about US$1.13], prices that have remained unchanged since 1990. Next month, the doughnuts may go up to 60 cents and the Black Forest cake to $2.
Said Mr Leong: “In Singapore, you have bread and cake prices that are at least 10 years old. This is especially true for the HDB [government-subsidized housing] neighborhoods, where customers are very price-sensitive.”See http://straitstimes.asia1.com.sg.
- Do you think bakers face a demand curve that is relatively elastic or relatively inelastic? Why?
- What has happened to their marginal cost?
- Explain the difference between a shift in the demand curve and movement along a demand curve.
- If you observe the price of a product, then you can infer the marginal cost of the product if and only if the market is competitive. Explain.
- Suppose that the cost function for a product is given by total costs = 100 + 2,000 × quantity. Create a spreadsheet to calculate the costs for different levels of output and use it to produce a graph like Figure 7.5.1 "Changes in Revenues and Costs Lead to Changes in Profits".
- What prices are your local gas stations currently charging for gas? Do the stations generally have the same price for gas? If not, what would explain the differences in prices they set? Do the stations charge the same price all the time or does the price change? When the price changes, what might be the reason for that change?
- Think about the college you are attending. What determines the profit of the college—what are its revenues and what are its costs? What is tuition at your college? Would you advocate an increase or a decrease in tuition rates to increase revenue at your college? What factors determine the elasticity of demand faced by your college?